Trader’s Narrative

Breadth is an important element of technical analysis that usually gets ignored for pure price action. But every once in a while, it is helpful to pop the hood and take a look at what is driving the price action in the indexes.

A simple way to measure breadth is to look at new 52 week highs relative to new 52 week lows. A healthy bull market will have a persistent bias towards new highs as most shares on exchanges trades to make new highs.

The indicator below is the New Highs New Lows Index for the Nasdaq. And it is based on a basic formula: new 52 week highs divided by the sum of the new highs and the new lows. It varies from zero to 100. When it is zero, it means that we have absolutely no new 52 week highs (with every single stock trading at a new 52 week low). This is a very rare and exceptionally oversold market. The reverse would be 100 with all shares at 52 week new highs.

Naturally, it is a very good timing indicator which I’ve used before to find inflection points in the market: Can the New High New Low Indicator do it again?

Since it can be rather volatile, I’ve used a 10 day simple moving average to smooth it out and provide a more meaningful chart:

We’ve moved very quickly from the extreme lows in March (where the 10 day moving average was 0.48%!) to 88% in recent trading.

Historically, when the 3000 or so constituents of the Nasdaq Composite start trading at 90% new highs, the market has a tough time moving up. We either enter into a range to work out the overbought or fell lower. Often times significantly lower.

The only exception to this in recent history was the powerful new bull market in 2003. New 52 week highs, relative to 52 week lows, as measured by this indicator continued to levitate at the extreme edge, reaching almost 100% for about 12 months as the stock market powered ahead.

The other interesting portion of the chart is the divergence shown in 2000 as the market was topping. Even as priced reached for the heavens, there was a complete collapse in the number of stocks reaching 52 week highs. You can see a similar divergence happened in mid 2007 as the S&P 500 once again climbed over 1500.

So the question continues to be: is this another bear market rally or like early 2003, the start of something much more?

The only way to know is to watch for price action in the face of overbought indicators like this one. If the S&P 500 continues to trade higher, shrugging off this and other indicators pointing to an overbought condition, then it is clear that what we are seeing is not just a regular bear market rally.

The market is bumping its head against a resistance range from 1400 to 1450. This area was of course, support just a few months back.

Starting from April 18th, I noticed a change in the market tone. Whereas pretty much every single indicator had been flashing buy in January, February and March, one by one, they started to point to caution:

• too many stocks above their 10 day moving average
• a fourth attempt at the 1400 level
• AAII sentiment back to October 2007 bullishness and the ISE call put ratio too high
• trading volume low enough to cause concern
• 78% of S&P 500 stocks above their 50 day moving average
• “Sell in May and go away!”
• market stretched above its 50 day moving average
• AAII sentiment inches even more to bullish excitement
• number of S&P 500 52 week highs compared to 52 week lows signals caution

The best scenario for the bulls would be for the market to pause here and digest this overbought condition and then continue to move higher, breaking above the flag or pennant formation.

Like other times of inflection in the stock market, we are seeing technical studies and indicators light up like a Christmas tree. So why not throw another couple stats on the pile? Below are the charts of new 52 week lows for the Nasdaq and the NYSE.

Similar to other indicators I’ve mentioned recently, this one spiked to a multi-year high last Tuesday (January 22nd 2008). In fact, you’d have to go back to the market turmoil we saw in 1998 to find a higher number of new lows!

The NYSE graph looks different mainly because a significant portion of the securities traded there are non-common stock but rather bonds, municipal bond funds and structured funds which are sensitive to interest rates. Nevertheless, we can see the same pattern.

As with the weight of all the indicators that I’ve looked at, this one is saying that it is time to look for buying opportunities, rather than selling or selling short.

Another horrible day on Wall Street with pretty much the whole screen in red. Fear and loathing is getting thick. The only redeeming characteristic of the market is that we are seeing technical signals of extreme oversold all over the place:

Option Traders
ISEE Sentiment Index reached 60 - meaning for every 100 puts, 60 calls were purchased by retail traders. The last time it was in this range was in March 2007 and August 2007.

The CBOE (equity only) put call ratio almost reached the magical 1.0 level again - the second time this week. Both of these indicators are showing a lot of fear in the options market, especially from retail traders. Which is great from a contrarian perspective.

Volatility
Until today, the VIX index had been surprisingly muted. Not any more. It spiked 17% to almost 29. And more importantly, relative to its moving average it is now within reach of an extreme high that has marked previous market troughs. But as Bill (the expert on the VIX) explains, we can certainly bottom without any sort of spike in volatility.

Market Internals
On the big board, there were 2,694 declining stocks and only 475 advancing ones. Likewise, declining volume surged to 1,957,006,000 while advancing volume was only 206,905,000. Things were similarly bleak on the Nasdaq.

My guess is we just had another another 90-90 (Lowry’s) down day. The previous one was January 11th 2008. Back to back 90-90 down days are normal. What we need next is a decisive 90-90 up day now.

Market Breadth
Wherever I look, there are indicators of a very oversold market. The bullish percent charts of the Nasdaq, NYSE and the S&P 500 are showing either 52 week lows or multi-year lows:

Likewise, the charts of indices for the percentage of stocks above moving averages are at extreme lows. For example: less than 11% of S&P 500 stocks are above their 50 day moving average. And less than 20% above their 200 day moving average.

Same thing for the new high-new low index for various markets. It can always get even more critical but right now, that looks unlikely since most breadth indicators are hugging the redline extremes.

Capitulation
Finally, we’ve had a famous bull throw in the towel. Dan Sullivan, a newsletter writer and a veteran of the markets has liquidated his holdings and gone 100% cash. Usually a significant market bottom doesn’t arrive until it shakes out all but the most resolute bulls.

Considering everything, I just can’t see how this is the beginning of a bear market. Usually they are accompanied by euphoria, good news and smooth sailing but now we are seeing crisis after crisis, panic, fear and loathing. Just the sort of thing that builds a wall of worry… which a bull market climbs.

So after warning you that we were headed into some shaky grounds on Monday morning (premarket) when the S&P 500 stood above 1540. And after the market fell to around 1510, saying that we had still some more room to the downside… Let’s see if I can continue this streak.

Lowry’s 90/90
No question today’s market action was severe. No doubt it was a Lowry’s “90/90″ day - where 90% of the points and 90% of the volume are on the downside. From the 3417 issues on the NYSE, 3144 of them closed down. That’s 92% to be exact. Meanwhile, volume on the NYSE was 95% to the downside.

Can you say e-x-t-r-e-m-e?

This is the sort of panicked, thorough selling that market inflection points are made of.

New Highs New Lows
This week I mentioned a few indicators that I was watching. The Nasdaq’s New Highs/New Lows indicator told me that we had more room to fall as it was still above 10. Today’s devastating decline took this indicator to just below, at 9.39. At these levels we can start to seriously look for a bottom.

Today, the New High/New Low Ratio also fell to extreme oversold levels. According to these two indicators, the number of 52-week lows (compared to highs) presents a compelling argument to go long.

Leaving aside market internals, a simple glance at the chart of the S&P 500 gives us a hint that the market may find its footing here. The February 2007 top which previously acted as resistance but can now become support:

Usually I leave volume off my charts but check out the volume today! Notice how in previous market inflection points, the surge in volume coupled with a wide range dark candle tends to signal a change in trend?

Most common indicators swung to extremes: The volatility index (VIX) spiked above 23 and met my request to go a tad higher. And the put/call ratio also spiked to a bullish extreme.

But the indicator of market health that I give a lot of weight to still hasn’t reached the kind of wash-out extreme that I’d like to see:

I’d prefer to see a real washout that would be a reading of 20-something. Similar charts for other percentage of stocks above 50 day moving average for indices like the Nasdaq 100 are also low but not low enough yet.

We could still bounce from here, especially as a gap up open tomorrow morning. That’s why right after 3pm I bought a bit of Ultra S%P 500 Proshares (SSO). The last hour of trading is known as “contra-hour” for good reason

What I’m most interested in seeing is how sentiment reacts to this recent decline in the markets. If we have real fear (increase in bearish sentiment), then we are probably all clear for another leg up in the bull market. But if people are complacent and do not flinch, things could get ugly.